Are you paying yourself what you are worth?

What Matters: Paying yourself an income

Andrew Penny hung out his shingle as a management consultant in 1997. Initially he ran his consulting firm, Ottawa-based Kingsford Consulting, as a one-man operation out of his home. But even in those early days he was very clear about the value he had in the marketplace and what that value would generate in terms of income.

He also viewed any difference in what he was earning in terms of salary versus what he could be earning working for someone else as an investment in his own business — one that he would earn a return on down the road. It’s a view many small business owners focused on putting every penny into the business in order to get going often don’t appreciate and they should, Mr. Penny says.

Today, Kingsford Consulting has its own offices, a team of nine and advises growing companies. “We are a larger business now with staff and associates and we do the same thing. We look at how much we can reinvest and grow the business that way,” Mr. Penny says. “As a business person you have value and you should understand what that value is. Then look at the delta between the value and what you are drawing and recognize the gap for what it is — an investment in the business. We deal with many business owners who are now reaping the reward of early investment and paying themselves, two, three, four times market value in salary and working very closely with tax advisors to strategically realize that income in a tax smart way. They are able to do that because they understood their market value in the beginning and now they are taking the return on that initial investment.”

Mr. Penny also makes the case that viewing any salary you are willing to forego as an investment keeps you focused on the fact you have to earn back that investment. It’s a business driver that will help put you on track to earn the income that will allow you to live the lifestyle you want — the objective for starting a business in the first place.

Determining how much income you will take comes down to answering a key question. Are you creating a job for yourself or are you creating a company? If the answer is the former, then you can take just about all of the profit out of the business to pay yourself, Mr. Penny says. “You just have to make sure what you are taking out in terms of a salary or wealth is comparable to what you would make if you were employed by someone else. That’s the baseline.”

Whether a company is a business comes down to intent, he says. “You may have only two people in a company, but if the intent is to achieve $1-million in revenue in year two, in other words, if there is a growth component, then it’s a business and a series of other issues come into play.”

For example, to build a growing business, owners will have to make an upfront investment to travel, to buy furniture, to buy equipment to build websites to market their services/products. “You are putting money into the business and any time you put money into something you need to create value. You want a return on investment,” Mr. Penny says. “The reward will be a blend of lifestyle and a share of the wealth being created by the company, which may come in the form of a salary, equity, dividends or retained earnings, for example. Bottom line you should be able to pay yourself a wage reflective of the market and be able to reinvest a percentage of net profits in the business. It’s important for a business owner to think about both these things: you should earn your salary and have re-investable profits.”

Yet, as David Simpson, who teaches entrepreneurial finance and heads the Business Families Centre at The University of Western Ontario’s Richard Ivey School of Business, points out, many entrepreneurs, particularly in the startup phase, aren’t thinking in those terms. “In most pitches for funding when you’re looking at the line items, there are no salaries. It’s great to say you have skin in the game, but you can’t just wait until Year X before you start earning an income because things like housing and food cost money.

As an investor, when I see that I worry because if someone comes along and offers you a job, then I’m stuck. I encourage entrepreneurs when raising capital to put in a market rate for their services, then discount it by a subsistence factor. Here is what I’m drawing and the balance is my earned equity. If founders are not paying themselves from Day 1, that’s a red flag.”

In terms of how to take money out of the business, Mr. Simpson says it’s typically better for people in a corporate structure to take dividends because the corporate tax rate is lower than the personal tax rate. “One strategy to consider when you are reinvesting business profits to grow pay yourself a management fee that is within your personal tax rate threshold and the rest in the form of shareholder dividend,” he says. “The key is to give yourself flexibility to ensure you are paying the minimum amount in tax.”